Your
Sunday "Market Watch" column was most interesting in reviewing another unusual
period of our history where a bear market in stocks coincided with a fall in
interest rates. In the period between 1872 and 1877, equity prices declined by
34% even as corporate bonds — railroad issues, for example — declined to 4%
from 5%. You write that "There was no Federal debt yet — imagine!" But you
were misled on that point, as a considerable debt accumulated before and
during the Civil War. It is correct that stock prices had risen in the 1860s
until 1872, but you fail to point out that the government had suspended the
gold standard in 1862, in effect "floating" the dollar as an inconvertible
greenback. This explains most of the stock market rise, as the dollar gold
price climbed to $40 per oz. from $20.67 per oz. and the stock market rose
with it. In other words, most of the rise was pure inflation. The fact that
stocks climbed a bit higher than the doubling of gold by 1865 in terms of
greenbacks reflected the market's discounting of the Union victory. The value
of Confederate bonds of course vanished.

The decision to return to gold
at $20.67 from roughly $40 also explains the phenomenon you described Sunday,
Gretchen. The stock market in 1872 turned south as it became increasingly
clear the federal government would return to the gold standard — at some price
closer to $20.67 than $40. In the 1873 act that did so, the holders of federal
bonds successfully argued that they should not be penalized for having bought
the bonds prior to the war. The decision was made to phase in the $20.67 price
over a six-year period, and to make the dollar fully convertible on January 2,
1879.

This was an extremely painful period of true monetary deflation
for Americans who had acquired debts while the gold price was high. Farmers
who had borrowed against their land when wheat was $1 a bushel were squeezed
unmercifully as wheat dropped to 50 cents, where it had been prior to the war.
Workers who had borrowed when wages were $2 a day were also crushed as
businessmen had no choice but to cut their wages back to $1 a day, the wage
prior to the greenback era. The bond market enjoyed the steady increase in the
purchasing power of dollar bonds. The bear market in stocks reflected the
painful adjustment to the monetary deflation, although it must be noted that
share prices also increased in purchasing power as the gold price halved. The
market rise that began in 1877 anticipated the boom that followed resumption
in 1879.

The current bear market on Wall Street, even as interest
rates decline, reflects the decline in the dollar price of gold over the past
18 months, to $285 from $385. The commodity deflation struck other parts of
the world first, because the United States has become primarily a service
economy and because the 1997 tax cuts fueled capital formation in the service
sector. Because all prices eventually have to adjust to the low gold price, an
increase in dollar liquidity by the Fed is about the only way to avoid further
declines in equity prices even as bond prices rise with falling interest
rates. A capital gains tax cut also would lift equities, but could not end the
deflation. Both Steve Forbes and Jack Kemp have urged this course of action
until gold reaches at least a $325 level, which would pull up commodity prices
around the world, enabling debtors to pay their creditors.

The
mistake almost all economists make is confusing a deflation with a
contraction. Because gold is the truest signal of a shortage or surplus of
dollar liquidity — the former deflationary as gold falls in price, the latter
inflationary as gold rises in price — the Great Depression cannot be
considered a deflationary era. Because the gold price was held constant until
President Roosevelt devalued the dollar in 1934 to $35 an oz., the era must be
properly characterized as a contraction.